Module 3 Chapter 05

Chapter 5
Risk Analysis
Introduction
• Risk is some measure of exposure to a

specified type of loss. The key to this general
definition is what loss is specified
• by U.S. GAAP and IFRS require disclosures to
inform financial statement users about specific
risks that can affect a firm and how the firm
manages those risks.
Chapter: 05 2
Financial Statement Analysis of Risk
Types of Risk:
Financial flexibility
Short-term liquidity risk
Long-term solvency risk
Credit risk
Bankruptcy risk
Market equity risk
Financial reporting manipulation risk
Chapter: 05 3
Financial Statement Analysis of Risk
• Firms use financial leverage to increase returns to
equity shareholders (Chapter 4).
• The analysis of profitability discussed in previous
chapter is linked to the analysis of risk discussed in
this chapter by an examination of financial
flexibility.
• Financial flexibility is the ability of a firm to obtain
debt financing conditional on its current leverage
and profitability of its operating assets.
Chapter: 05 4
Framework for Financial Statement Analysis of Risk
• The risk associated with leverage arises because

satisfying future debt retirements requires cash
payments.
• Exhibit below relates the factors affecting a firm’s
ability to generate cash with its need to use cash.
Chapter: 05 5
Disclosures Regarding Risk and Risk Management
The sources and types of risk a firm faces are numerous and often interrelated.
Most of these risks are unavoidable, and firms must continually monitor each
one to ensure that appropriate actions are taken to minimize the impacts of
detrimental
events or changes in circumstances
Chapter: 05 6
Analyzing Financial Flexibility
• Financial leverage can enhance the return to

common shareholders.
• Common shareholders benefit with increasing
proportions of debt in the capital structure as
long as the firm maintains a rate of return on
assets above the after-tax cost rate of the
debt. Therefore, financial leverage can
enhance the return to common shareholders.
Chapter: 05 7
Analyzing Financial Flexibility
• Disaggregation of ROCE provides insight about

the degree of benefit derived from using
leverage.
• Higher leverage generally suggests greater
financial risk.
• Risk is primarily attributable to the costs of
borrowings.
Chapter: 05 8
Analyzing Short-Term Liquidity Risk
• Firm’s ability to satisfy payment obligations to
suppliers, employees, and creditors for short-term
borrowings, the current portion of long-term debt,
and other short-term liabilities.
• Measures a firm’s ability to generate sufficient cash
to supply operating working capital needs and to
service debts.
Chapter: 05 9
• Operating cycle of a firm: length of time it takes a
company to buy raw materials / inventory, convert it
finished goods, sell the finished goods inventory on
credit, and convert the "accounts receivable" to
cash (collection).
Chapter: 05 10
Chapter: 05 11
Short-term liquidity problems can arise from:
1.Untimed cash inflows and outflows.
When firms cannot time their cash inflows and
outflows precisely, especially firms in the start-up
or growth phase
2.High Degree of long-term leverage.
This level of debt usually requires periodic interest
payments and may also require repayments of
principal.
Chapter: 05 12
Short-Term Liquidity Risk (Contd.)
Financial statement ratios for assessing short-
term liquidity risk:
•Current ratio
•Quick ratio
•Operating cash flow to current liabilities ratio
•Accounts receivable turnover
•Inventory turnover
•Accounts payable turnover
Chapter: 05 13
Current ratio:
• Current ratio: It indicates the amount of cash
available and other current assets of the firm,
relative to obligations coming due.
• current ratio = Current Assets / Current Liabilities
Current ratio for PepsiCo at the end of 2012 is $18,720 / $17,089 = 1.10 /1
• The current ratio for PepsiCo was 0.96 at the end of 2011.
Chapter: 05 14
Current ratio:
• Banks, suppliers, and other short-term creditors generally
prefer a current ratio in excess of 1.0.
• Should be assessed in the context of other factors affecting
a firm’s liquidity (length of the firm’s operating cycle,
expected cash flows from operations, etc).
• Firms attempt to stretch their accounts payable and use
suppliers to finance a greater portion of their working
capital needs.
• JIT
Chapter: 05 15
• Additional interpretive issues should be considered when
evaluating the current ratio:
• For certain firms, a very high current ratio is not desirable and
may accompany poor business conditions, whereas a very low or
decreasing ratio may be a sign of financial health, and may
accompany profitable operations.
• The current ratio is susceptible to window dressing; that is,
management can take deliberate steps prior to the balance sheet
date to produce a better current ratio than is the normal or
average ratio for the period.
Chapter: 05 16
• Quick ratio:
– Also called as Acid Test Ratio.
– Includes in only those current assets the firm could
convert quickly into the cash (Cash, Marketable securities
and Receivables).
• Quick Ratio =
Cash and Cash Equivalents + Short-Term Investments +Accounts Receivable
Current Liabilities
The quick ratio for PepsiCo was 0.62 and 0.80 at the end of 2011
and 2012 respectively.
Chapter: 05 17
Pepsi
Year (Most recent in far right column.) 2011 2012
Year 2011 2012 Assets:
Cash and cash equivalents 4,067 6,297
Marketable securities 358 322
LIQUIDITY: Accounts and notes receivable—net 6,912 7,041
Current Ratio 0.96 1.10 11,337 13,660 0.205
Inventories 3,827 3,581
Quick Ratio 0.62 0.80 Prepaid expenses and other current assets 2,277 1,479
Operating Cash Flow to Current Liabilities 52.5% 48.1% Current Assets 17,441 18,720 0.073
Current Liabilities 18,154 17,089 -0.059
• Current and quick ratios for PepsiCo follow the same upward trend.
However, the increase in the quick ratio is more pronounced.
• In 2012, current assets increased 7.3%, whereas current liabilities
decreased 5.9%.
• Marketable securities, and accounts receivable increased 20.5% in 2012,
leading to the increase in these amounts relative to current liabilities. Thus,
the discrepancy between the current ratio and quick ratio for PepsiCo is due
to changes in less liquid current assets.
Chapter: 05 18
Operating cash flow to current liabilities: It indicates the
amount of cash from operations after funding working
capital needs.
Operating Cash Flow to Current Liabilities Ratio =

Cash Flow from Operations
Average Current Liabilities
The ratio was 0.48 and 0.41 for 2012 and 2011
respectively.
Chapter: 05 19
Working capital activity ratios:
Rate of activity measures used to study cash-generating ability
of operations and short-term liquidity risk of a firm are:
These turnover ratios are often stated in terms of the number of

days each balance sheet item (that is, receivables, inventories, and
accounts payable) is outstanding. To do so, divide 365 days by each
turnover metric.
Chapter: 05 20
Chapter: 05 21
Chapter: 05 22
Days Inventory Held 44

+ Days Accounts Receivable Outstanding 39
= Days of Working Capital Financing Required 83
- Days Account Payable Outstanding 47
= Days of Working Capital Financing Needed from Other Sources 36
Chapter: 05 23
PepsiCo used short-term borrowing to finance part of the net days of needed
financing.
Chapter: 05 24
Analyzing Long-Term Solvency Risk
Examines a firm’s ability to make interest and
principal payments on long-term debt and
similar obligations.
Three measures used to examining long-term
solvency risk are:
Debt ratios
Interest coverage ratio
Operating cash flow to total liabilities ratio
Chapter: 05 25
Long-Term Solvency Risk (contd.)
Debt Ratios:
It is used to measure the amount of liabilities,
particularly long-term debt in a firm’s capital
structure.
The higher this proportion, the greater the long-
term solvency risk.
It is the alternative computation of leveraged
used in the ROCE, in previous chapter.
Chapter: 05 26
Long-Term Solvency Risk (contd.)
Commonly used measures of Debt Ratios:
Total Liabilitie s
Liabilitie s to Assets Ratio 
Total Assets
Total Liabilitie s
Liabilitie s to Shareholde rs’ Equity Ratio 
Total Shareholde rs’ Equity
Long - Term Debt to Long - Term Capital Ratio

Long - Term Debt

Long - Term Debt Total Shareholde rs’ Equity
Long - Term Debt

Long - Term Debt to Shareholde rs’ Equity Ratio 
Total Shareholde rs’ Equity
Chapter: 05 27
Analyzing Long-Term Solvency Risk
Chapter: 05 28
Long-Term Liquidity Risk (Contd.)
SOLVENCY: 2010 2011 2012

Total Liabilities / Total Assets 68.5% 71.3% 70.0%
Total Liabilities / Total Equity 217.3% 248.7% 233.2%
LT Debt / LT Capital 48.2% 49.6% 51.2%
LT Debt / Total Equity 93.1% 98.4% 105.1%
Median PepsiCo
firm
liabilities to equity ratio 1=100% debt ratios are somewhat higher. This is
liabilities to assets ratio 0.5 expected given PepsiCo’s size,
profitability, and strong capacity for
debt financing.
Trend Analysis: The debt ratios involving total liabilities show a slight decrease
from 2011 to the end of 2012. The same is true for the long-term debt ratios,
although the pattern is more steadily decreasing.
Chapter: 05 29
• You should use caution when discussing debt ratios.
For example, a liabilities to shareholders’ equity ratio
greater than 1.0 is not unusual, but a liabilities to
assets ratio or a long-term debt to long-term capital
ratio greater than 1.0 is highly unusual.
• you may gather information from the financial
statement footnote on long-term debt. The note
includes information on the types of debt a firm has
issued and their interest rates and maturity dates.
Chapter: 05 30
• You should recognize the possibility of some actions
when interpreting debt ratios and perhaps adjust the
reported amounts. For example, companies, to
appear less risky, often structure leases to qualify as
operating leases instead of capital leases to minimize
reported long-term debt.
Chapter: 05 31
• Interest coverage ratio:
– It indicates the number of times a firm’s income or
cash flows could cover interest charges.
SOLVENCY: 2010 2011 2012

Interest Coverage Ratio (reported amounts) 10.1 11.3 10.2
Chapter: 05 32
SOLVENCY: 2010 2011 2012
• PepsiCo’s interest coverage ratio stayed within a relatively stable

range.
• Analysts typically view coverage ratios of less than 2.0 as indicators
of solvency risk. By this measure, PepsiCo exhibits very low long-
term solvency risk.
• One criticism of the interest and the fixed charges coverage
ratios as measures of long-term solvency risk is that they use
earnings rather than cash flows in the numerator. Firms pay
interest and other fixed charges with cash, not earnings.
• Interest Coverage Ratio (Cash Flow Basis) :
Chapter: 05 33
SOLVENCY: 2010 2011 2012
• Interest Coverage Ratio (Cash Flow Basis) :
Chapter: 05 34
 Operating cash flow to total liabilities ratio:
• Standard debt ratios give no recognition to the ability of a firm to
generate cash flow from operations to service debt.
• This ratio overcomes this deficiency
2010 2011 2012

Operating Cash Flow to Total Liabilities 24.5% 18.1% 16.3%
A ratio of 0.20 or more is common for a financially healthy company. Thus,
PepsiCo appears to be in the range of financially healthy companies
Chapter: 05 35
Analyzing Credit Risk
• Potential lenders to a firm, assess the likelihood that the firm
will pay periodic interest and repay the principal amount.
• Lenders may use following checklist as factors.
– Circumstances leading to need for loan.
– Credit History
– Cash flows
– Collateral
– Capacity for debt
Contingencies
Character of Management
Communication
Conditions or covenants
Chapter: 05 36
• Circumstances leading to need for loan.
The reason a firm needs to borrow affects the riskiness of the
loan and the likelihood of repayment.
Example : Toys‘‘R’’Us purchases toys, games, and other entertainment products in
September and October in anticipation of heavy demand during the holiday
season. It typically pays its suppliers within 30 days for these purchases but does
not collect cash until December, January, or later.
• To finance its inventory, Toys ‘‘R’’Us borrows short term from its banks. It repays
these loans with cash collected from customers. Lending to satisfy cash-flow needs
related to ongoing seasonal business operations is generally relatively low risk.
• Toys‘‘R’’Us has an established brand name and predictable demand. Although
some risk exists that the products offered will not meet customer preferences in a
particular year, Toys‘‘R’’Us offers a sufficiently diverse product line that the
likelihood of failure to collect sufficient cash is low.
Chapter: 05 37
• Credit History
• Has a firm borrowed in past and has it successfully
repaid it?
• Poor credit history can doom a firm to failure.
• Cash Flows
• Lenders prefer that firms generate sufficient cash flows to pay interest and
repay principal (collectively referred to as debt service) on a loan rather
than having to rely on selling the collateral.
• Tools: examining the statement of cash flows for recent years, computing
various cash flow financial ratios, and cash flows in projected financial
statements.
Chapter: 05 38
Analyzing Credit Risk (contd.)
• Collateral
• availability and value of collateral for a loan. If a company’s
cash flows are insufficient to pay interest and repay the
principal when due, the lender has the right to take
possession of any collateral pledged in support of the loan.
• The following are commonly collateralized assets:
marketable securities; accounts receivable; inventories;
property, plant, and equipment; and intangibles.
Chapter: 05 39
• Capacity for debt
 Firm’s capacity to assume additional debt.
 Most firms do not borrow up to the limit of their debt
capacity, and lenders like to see a ‘‘margin of safety.’’
• Contingencies
 You should assess the likelihood that contingent outcomes
(lawsuit as example) occur.
 This requires you to read the notes to the financial
statement carefully and to ask questions of management,
attorneys, and others.
Chapter: 05 40
Character of Management
 An intangible that can offset to some extent weak signals
about the creditworthiness of a firm.
 Has the management team successively overcomed
previous operating problems and challenges that could
have bankrupted most firms?
 Lenders are more comfortable lending to firms in which
management has a substantial portion of its personal
wealth invested in the firm’s common equity.
Chapter: 05 41
Communication
 Throughout the term of a loan, borrowing firms are frequently
required to communicate regularly with lenders.
 Lenders do not like surprises, so they monitor the firm’s
profitability and financial position
 Conditions or covenants
 Lenders often place restrictions, or constraints, on a firm to
protect their interests.
 Such restrictions might include minimum or maximum levels of
certain financial ratios. For example, the current ratio cannot
fall below 1.2
Chapter: 05 42
Analyzing Bankruptcy Risk
• Models for bankruptcy prediction
Univariate bankruptcy prediction models:
Examines the relation between a particular financial
statement ratio and bankruptcy.
Multivariate models
Combine several financial statement ratios to
determine whether the set of ratios together can
improve bankruptcy prediction.
Chapter: 05 43
• Models for bankruptcy prediction
1. Univariate bankruptcy prediction models:
 Ratios list includes profitability, short-term liquidity
risk, and long-term solvency risk ratios.
 Beaver’s best predictor was : Net Income plus
Depreciation, Depletion, and Amortization/Total
Liabilities (long-term solvency risk).
Chapter: 05 44
2. Multiple Discriminant Analysis (MDA):
•A multivariate statistical technique, to develop bankruptcy
prediction models.
•We select a sample of bankrupt firms and matched them with
healthy firms of approximately the same size in the same industry.
This matching procedure attempts to control factors for size and
industry.
•So, we can examine the impact of other factors that might
explain bankruptcy. We can then calculate a large number of
financial statement ratios expected to explain bankruptcy.
Chapter: 05 45
•Using these financial ratios as inputs, an MDA model selects
the subset (usually four to six ratios) that best discriminates
between bankrupt and nonbankrupt firms.
•The resulting MDA model includes a set of coefficients that,
when multiplied by the particular financial statement ratios and
then summed, yields a multivariate score that is the basis of
predicting the likelihood of a firm going bankrupt
Chapter: 05 46
Analyzing Bankruptcy Risk (Contd.)
• Altman’s Z-score
Z-Score =
([Net Working Capital / Total Assets] x 1.2)
+ ([Retained Earnings / Total Assets] x 1.4)
+ ([Earnings before Interest and Taxes/ Total Assets] x 3.3)
+ ([Market Value of Equity/ Total Liabilities] x 0.6)
+ ([Sales/ Total Assets] x 1)
Chapter: 05 47
Z-Score: Each ratio captures a different dimension of profitability or risk as
follows:
1.Net Working Capital/Total Assets: This ratio serves as a measure of short-
term liquidity risk.
2.Retained Earnings/Total Assets: Accumulated profitability and relative age of
a firm.
3.Earnings before Interest and Taxes/Total Assets: This ratio measures current
profitability
4.Market Value of Equity/Book Value of Liabilities: this ratio measures long-
term solvency risk and the market’s overall assessment of the profitability and
risk of the firm.
5.Sales/Total Assets: the ability of a firm to use assets to generate sales.
Chapter: 05 48
Bankruptcy prediction models using multiple discriminant
analysis (MDA):
• Altman’s Z-score
Z-score probability of bankruptcy
Less than 1.81 High
Between 1.81 and 3.00 gray area
Greater than 3.00 Low
RISK FACTORS:
Bankruptcy Predictors: 2010 2011 2012
Altman Z Score 3.34 3.29 3.33
PepsiCo’s Z-score of 3.33 clearly indicates a low probability of bankruptcy.
Chapter: 05 49
3. Bankruptcy prediction models using Logit Analysis:
• The use of logit analysis to develop a bankruptcy prediction model
follows a procedure that is similar to that of MDA: (1) initial
calculation of a large set of financial ratios, (2) reduction of the set of
financial ratios to a subset that best predicts bankrupt and nonbankrupt
firms, and (3) estimation of coefficients for each included variable.
• The logit model defines the probability of bankruptcy as follows:
1
Probabilit y of Bankruptcy for a firm 
1  e y
Chapter: 05 50
Bankruptcy prediction models using Logit Analysis:
1
1  e y
• Where e equals approximately 2.718282. The exponent y is a
multivariate function that includes a constant and coefficients for a set
of explanatory variables (that is, financial statement ratios that
discriminate bankrupt and nonbankrupt firms).
Chapter: 05 51
1
1  e y
• We convert the Z-score into a probability of bankruptcy using the
normal density function in Excel.
Z-score translates into a probability of bankruptcy probability of
bankruptcy
1.81 20.90% High
between 1.81 and 3.00 between 2.75% and 20.90% gray area
3 2.75% Low
Chapter: 05 52
1
1  e y
RISK FACTORS:
Bankruptcy Predictors: 2008 2009 2010 2011 2012
Altman Z Score 5.05 5.45 3.34 3.29 3.33
Bankruptcy Probability 0.00% 0.00% 0.96% 1.11% 0.98%
Chapter: 05 53

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Module 3 Chapter 05

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Chapter 5

• Risk is some measure of exposure to a

• The risk associated with leverage arises because

• Financial leverage can enhance the return to

• Disaggregation of ROCE provides insight about

Operating Cash Flow to Current Liabilities Ratio =

These turnover ratios are often stated in terms of the number of

Days Inventory Held 44

Long - Term Debt to Long - Term Capital Ratio

Long - Term Debt

SOLVENCY: 2010 2011 2012

SOLVENCY: 2010 2011 2012

• PepsiCo’s interest coverage ratio stayed within a relatively stable

• Interest Coverage Ratio (Cash Flow Basis) :

2010 2011 2012

PepsiCo’s Z-score of 3.33 clearly indicates a low probability of bankruptcy.

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